2. The UK must maximise openness to the global economy to help tackle the
productivity challenge

Chapter 2

Chapter 2 - The UK must maximise openness to the global economy to help tackle the
productivity challenge

The UK faces a productivity challenge that acts as a drag on its trade performance across
the board. Despite some progress in closing the gap, prior to the global financial crisis
the UK was less productive than most comparable large developed economies. For the UK to pay
its way in the world, and capitalise on those growth opportunities occurring across the
globe, it must maximise openness to boost productivity and become more competitive.

Globalisation and the rise of emerging markets present a great opportunity for Britain.
Openness to global exports, imports, investment and migration combined with the right
industrial strategy and policies to boost skills levels can drive a virtuous circle of
increased productivity and competitiveness that will support growth and exports, creating
jobs and boosting prosperity.

In the current wave of globalisation, the world economy is becoming more open and
integrated, with tariff barriers lower than ever before and non-tariff barriers being
lowered to help facilitate a boom in supply-chain trade. However, it is increasingly
difficult to make progress through multilateral deals at the World Trade Organization, with
the Doha Round struggling to deliver results since its inception in 2001. Instead, a variety
of bilateral and regional trade deals are taking the lead in dismantling trade barriers –
for example, for the last few decades the UK has used membership of the European Union as
the vehicle for pursuing greater openness.

2.1 The key to increasing exports is meeting the productivity challenge through continued
openness of the UK economy

Long-term sustainable GDP growth is driven by improvements in productivity, especially in
developed economies where workforce growth, catch-up capital accumulation and natural
resources are limited (see Exhibit 11). By enabling resources and labour to be used more
intensively, productivity growth both increases the overall size of an economy and improves
real income and the standard of living. And, by raising efficiency and lowering the cost of
goods and services, improvements in productivity raise a country’s competitiveness, enabling
it to increase exports and participate in attractive high-value-added parts of global supply
chains. Success for the UK in the modern global economy will not rest on competing for the
lowest labour costs or handing out subsidies; it will instead be driven by boosting
productivity through skills, technology and innovation.

Exhibit 11: Improvements in productivity are the main drivers of growth
in mature economies

Exhibit 12: Much UK success comes from operating at high-value-added
parts of the global economy

The UK's motorsport sector is a jewel in the crown of UK
engineering and a hidden powerhouse of the UK economy with global sales exceeding £6
billion, employing 40,000 people at 4,000 mostly SME companies. Motorsport Valley UK is
home to 8 of 11 Formula 1 teams, more than at any time in history, all of which are
located amongst an innovative community of leading producers supplying a wide variety of
motorsport all over the world. Europe is the sector’s leading market, closely followed
by the US

The UK faces a substantial productivity challenge. For several decades, UK productivity has
lagged behind not only that of the high-productivity United States but also that of
comparable western European countries including Germany and France (see Exhibit 13).
From the 1980s up until the financial crisis, UK overall productivity grew more
rapidly than in other major advanced economies, but in 2007 it was still 9% below that of
Germany and 20% below that of the US (while it had just pulled equal with that of France).

-20%

UK productivity is a fifth lower than in the US

Since the global financial crisis in 2007, British labour productivity has declined sharply,
as employment has performed surprisingly strongly considering the depth of the recession.
While it remains unclear just how much of this shortfall in labour productivity is permanent
and how total factor productivity has been affected – there may be a rebound in the coming
years as GDP recovers – these figures underline the productivity and competitiveness
challenge that the UK faced even prior to the downturn.

Exhibit 13: Britain’s productivity has historically lagged that of other
advanced economies[1]

UK=100

France

West Germany/Germany

US

GDP/hour worked

1973

95

132

160

1979

112

157

166

1991

123

161/143

156

1995

117

133

146

2007

109

119

147

Total Factory Productivity (TFP)

1973

87

112

127

1979

103

135

135

1991

110

133/123

128

1995

104

115

123

2007

101

110

125

Source: Nicholas Crafts. The economic legacy of Mrs Thatcher, 2013

Greater openness and trade can feed into greater productivity in a virtuous circle

The UK has always been an open economy. However, by further opening its economy to exports,
imports, international skilled labour and capital, the UK can benefit from a virtuous cycle
of increased competitiveness, productivity and growth. Openness is promoted by:

Securing market access to trade in both exports and imports at every stage of the
value chain

Increasing access to labour and investment through migration and capital flows

Improving the business climate for foreign direct investment

Having a regulatory climate that is both competitive and enabling to trade.

Empirically, the link between international openness and productivity growth is backed by a
study of 93 countries by the National Bureau of Economic Research (NBER), which found a
clear link between openness and trend productivity growth, even after controlling for
reverse causality (as well as openness driving productivity, increased productivity can
drive greater openness).[2]

To manage this openness effectively, however, domestic policy needs to be adapted to ensure
that the UK economy is best placed to face the opportunities and challenges that being open
to globalisation brings. The creation of an appropriate industrial strategy to maximise
investment in productive sectors is essential, as is the need for suitable measures to
handle the transition costs of structural changes to employment, managed migration, and
skills policies to make sure the UK stays ahead of its competitors.

Exhibit 14: Openness to trade, investment and migration can drive a virtuous circle and increase productivity and prosperity when combined with an industrial strategy and measures to handle transition costs

Exhibit 14 shows how openness to trade, investment and people can drive the economy to
greater productivity and prosperity. Trade expands the market available to domestic firms,
allowing them to expand and exploit economies of scale. Domestic industries that do not
export themselves but who supply other exporters will also participate in the growing hub.
Furthermore, imports of intermediates and participation in global supply chains, together
with the utilisation of international skills, capital and knowledge, also enable increased
specialisation and scale. Meanwhile competitive pressures from abroad will drive domestic
innovation and adoption of new technologies.

This results in improved labour and capital productivity, product quality and international
competitiveness. Together with domestic supply-side reforms, this openness allows domestic
industries to participate in high-value stages of global value chains. Over the longer term,
productivity gains drive structural changes to the patterns of production, with the creation
of specialised clusters that pull in foreign direct investment. This, in turn, enables
further success in trade, which sets off further rounds of productivity gains that boost the
living standards of UK citizens.

Weir Group is one of the UK’s largest industrial companies specialising in the
manufacture of high-tech pumps and valves for the energy and mining sectors. The
development of European and Global standards has supported the growth of Weir Minerals
Europe, the Group’s largest UK operation. The business exports more than 80% of its
products to more than 50 countries. Aided by the Single Market, sales growth in Europe
has been particularly strong, with new operations in Germany, Benelux, Scandinavia,
Ukraine, Hungary, Spain, Turkey and Poland.

Openness to movements of people directly helps the UK’s global role in a number of ways. It
can lead to direct economic benefits as citizens move across borders to travel and learn in
the UK, which is increasingly important to the tourism and education sectors as visitors
from high-growth economies begin to travel and be educated more widely. Immigration can also
help fill skills shortages for business, as well as facilitating cross-border management
structures for global companies. Finally, the immigrant population is reckoned to be a net
contributor to the public finances, largely because they are much more likely to be of
working age than the UK-born population.[3] Over the
long term, immigration could have a substantial positive impact on the UK’s fiscal position:
the Office for Budget Responsibility has projected that the public sector net debt could be
52% of GDP in 2060 with net migration of 260,000 per annum but that this could rise to as
high as 181% with zero net migration.[4]

But the case for increasing openness to labour and mobility of workers and consumers rests
not only on the balance of the direct benefits. There are significant indirect benefits to
openness too, especially in a world of increasingly open and interconnected economies:
making travel between countries as easy as possible is critical in building the personal
relationships that often underpin trade and investment partnerships.

Exhibit 16: Building outward links through openness to movement of people

AVF Group: For AVF Group, a mid-size company who sell mounts and stands for audio visual
equipment to corporate and domestic customers around the world, one major advantage of
the free movement of labour has been the ability to recruit staff from the EU in the UK
with language skills that enable the company to operate in new markets. For a company
with 37 employees in the UK, being able to recruit staff who speak French, Spanish and
German has opened up new opportunities. Additionally, the recent signing of a free trade
agreement between the EU and Colombia has helped break down many of the trade barriers
that is slowing growth for the company in the BRICs.

Pure openness can be challenging

Pure openness can be challenging and have social impacts in the short to medium term, as
shifts in the sectoral and employment composition of the economy cause dislocation effects
such as changes in the nature of job opportunities and the skills required to fill them.
Labour market impacts in particular necessitate active measures to promote re-skilling
throughout the workforce and spread the aggregate benefits arising from migration.

For some parts of the British economy, greater competition – both from other member states
and from outside the EU – has been damaging, with uncompetitive sectors migrating to other
markets. Industries and sectors that have struggled to compete internationally have seen
production moved outside the UK, both to EU states and further afield. For example, whereas
the UK was once a major shipbuilder and coal miner, the creation of – and access to – global
markets has dramatically reduced the UK’s industrial base in these sectors. UK shipbuilding
has not migrated to other EU countries; instead, South Korea and China now build 74% of the
world’s ships.[5]

For the UK to realise the benefits associated with openness, action at home is needed to
ensure it is positioned to compete on the world stage for the long term. This means business
and government working in partnership to put in place a coherent industrial strategy that
gets behind key sectors where the UK has competitive strengths and sees strategic future
opportunities, as well as developing a skills system that is demand-led . The CBI believes
that a coherent 21st-century industrial strategy for the UK needs to be anchored
around:

Improving the competitiveness of the business environment: Concerted action
is needed to improve and strengthen the competitiveness of the UK business environment in
the face of rising global competition. This means ensuring that the UK is competitive
relative to other countries on indicators such as business taxes, infrastructure quality,
access to finance, and education and skills.

Championing key sectors: A more targeted approach to supporting champion
sectors such as automotive, life sciences and the information economy is essential.
Strategic and open dialogue between business and government can help to unblock barriers to
growth in key sectors

Strengthening supply chains: By strengthening supply-chain competitiveness
and capabilities – especially among small and medium-sized suppliers – the UK has the
potential to capture more value from investments at home and ensure that more UK content is
included in the products and services exported overseas.

As the CBI’s recent Raising the Bar report argues, good progress is now being made
on the industrial strategy agenda but it needs to be consolidated for the long term through
effective implementation by government and business in partnership.[6] To be successful, industrial strategy must also be election-proof,
with commitment to continuity on key policy areas across the political divide.

Similarly, while the direct and indirect benefits of openness to movements of people are
significant for business, there may be a period of dislocation and adjustment for some
UK-born workers in certain sectors. An OECD study has encountered evidence of the temporary
impacts of immigration on UK labour markets: a 1 percentage point rise in the non-UK-born
share was found to increase UK-born unemployment by 0.4 percentage points two and three
years later, but have no impact thereafter.[7] The UK
needs to provide appropriate support for job search and training to ensure that any
temporary dislocation does not have permanent effects.

Managing openness through an industrial strategy, skills and appropriate migration policies
can help mitigate the uncertainty of globalisation while harnessing the opportunities it
brings, but it will not remove all of these concerns either from the public consciousness or
from the priorities of policymakers.

2.2. The world economy is generally becoming more open

The UK needs to continue to drive forward openness to take advantage of the opportunities
of globalisation because the rest of the world is doing so on an unprecedented scale. In
recent decades, barriers between the world’s economies have consistently diminished and
globalisation has transformed the way in which goods and services are produced and
delivered. World tariff barriers have fallen consistently over the last 20 years, with the
trend increasingly driven by developing countries (see Exhibit 17).

Exhibit 17: Tariff barriers have fallen through the world
in recent decades

Furthermore, non-tariff barriers (NTBs), such as regulatory divergence, state aid and
dumping, are also being dismantled, albeit from a much higher base and more inconsistently.
While NTBs are very difficult to measure in the aggregate directly, their declining impact
is evidenced in analysts’ estimates of ‘border effects’. Broadly, these estimates of the
aggregate impact of differing national markets, state structures and national cultures on
trade are obtained by estimating how much cross-border trade there ought to be based just on
fundamentals like geography, population and wealth. A recent study that estimated global
border effects from 1980 to 2006 found that they had declined consistently through the
period and by around a quarter overall.[8] However,
non-tariff barriers undoubtedly persist, and are limiting the ability of UK businesses to
seize potential opportunities around the globe: for example, US automotive export tariff
rates of between 0.5% and 1.5% rise to an effective tariff rate of over 20% when
one considers the NTBs that continue to exist due to regulatory divergence, severely
limiting the ability of firms to get into the US market.[9]

In addition, barriers to the mobility of people and capital are also in retreat. The
proportion of international migrants in the world population edged up from 2.9% to 3.1%
between 1990 and 2010 but it rose more markedly in Europe, from 6.9% to 9.5%. Global
cross-border capital flows, meanwhile, grew remarkably rapidly from the mid-1990s to the
financial crisis and, although they fell sharply in 2008–09, they have partially rebounded
and were estimated to be at 2005 levels in 2012 (see Exhibit 18).[10]

Exhibit 18:: Capital and people are increasingly internationally mobile

Bilateral and regional trade deals are taking the lead in dismantling tariff and
non-tariff barriers

Over the last decade, new commitments to maximise openness and access to the global economy
have been best achieved largely outside the WTO-led model of multilateral integration. The
lack of agreement to date in the Doha Round negotiations has contributed to a shift in
emphasis away from the traditional multilateral trade talks designed to reduce global trade
costs towards a mixture of bilateral and regional trade deals aimed at promoting deeper
integration of national economies.

Although its dispute resolution mechanisms are still integral to the global trading
landscape, the waning of the WTO model as a vehicle for securing new trade commitments has
been driven in part by a shift in international trading patterns throughout the second half
of the 20th century: at first trade between advanced economies was well served by
the WTO model, but rapid increases in global supply-chain trade and trade between advanced
and emerging economies, in combination with entrenched political blockages in WTO
negotiations, have meant that a different approach has been required to break down modern
trade barriers in recent years.

Among lower-middle economies, intra-industry trade began to take off from the 1980s
onwards, creating new complementary regional hubs alongside the more established high-income
country hub. In the 21st century, intra-industry trade is at the fore, and other
links are developing between these hubs, taking the world into a new phase of globalisation
(see Exhibit 19).

Exhibit 19: Trade links both within regions and between them are
increasingly important in the complex 21st century global economy

The effective operation of supply-chain trade requires that openness be taken well beyond
tariff and quota elimination to encompass other issues such as customs procedures and
intellectual property rights protection, regulatory harmonisation and capital and labour
mobility (see Exhibits 20 and 21). Such measures, some of which have been pushed at WTO
level by the EU, have so far been difficult to advance successfully at the multilateral
level and so have been pursued actively at the regional and bilateral level.

Exhibit 20: The new phase of globalisation

Airbus in the UK: Wings for the
entire family of Airbus are assembled at Broughton in North Wales before being shipped
to Hamburg and Toulouse where the final aircraft are assembled. With major manufacturing
sites in France, Germany, Spain and the UK, Airbus is a pan-European operation which has
benefitted from being able to operate across national borders without trade barriers of
tariffs.

Tariff barriers.
Although these have been eroded by successive multilateral trade rounds, high tariffs in
some countries still pose problems for EU exporters.

Burdensome customs procedures for import, export and transit
as well as unfair or discriminatory tax rules and practices.

Technical regulations, standards and conformity assessment
procedures that are not in line with WTO rules on Technical Barriers to Trade (TBT
Agreement).

Misuse of sanitary and phytosanitary measures i.e. those that are not
justified on health and safety grounds within existing WTO rules.

Restrictions on
access to raw materials, particularly restrictive export practices, including export
taxes, which drive up prices for products such as hides and skins, and key mineral and
metal goods, as well as dual pricing practices.

Poor protection of intellectual property rights including geographical
indications and the lack of proper implementation and enforcement.

Restrictive government procurement rules and practices that prevent EU
companies from bidding effectively for public contracts in third countries.

Abusive and/or WTO-incompatible use of trade defence instruments by third countries.

Unfair use of state aids and other subsidies by third countries in a way that
constitutes market access barriers

Emerging economies eager to accelerate their industrialisation (especially smaller
countries that do not enjoy the vast potential domestic markets of China and India),
together with developed economies looking for low-priced factor inputs, have facilitated the
rise of supply-chain trade with a series of reforms and trade deals made independently of
the WTO.[12]

As Exhibit 22 shows, the pace of regional trade deal-making has been picking up since the
mid-1990s and accelerated sharply once the Doha Round began to collapse. Almost all of the
world’s major economies are now part of regional multilateral free trade areas that go
beyond the WTO base, with China and Australia notable exceptions (see Exhibit 23).

Exhibit 23: Most countries are part of some form of regional
multilateral trade area

The pace of integration is nevertheless uneven, and different countries around the world
have adopted a variety of regional models of trade relations, often evolving from political
initiatives to promote peace and security, to enhance openness in a way that suits their
economic priorities and adapts to political constraints.

Some have prioritised a series of bilateral agreements that can be negotiated individually
to provide increased market access in different parts of the globe, as South Korea has done.
Others have also pursued their own FTAs, but at the same time have taken clear steps to be
part of a regional trading bloc with the objective of explicitly reducing trade barriers
(tariff and non-tariff) among participating members, such as ASEAN and NAFTA. A number of
countries have gone one step further to introduce a customs union with a common commercial
policy and a single external tariff, as Mercosur has tried to do, although with limited
success.

40yrs

The UK has used membership of the EU as a vehicle for 'openness' for four decades

Forms of economic union, such as the EU, have been even more ambitious, eliminating all
tariffs internally and attempting to fully break down non-tariff barriers to trade in an
effort to create a Single Market, for example through harmonised product regulation as well
as pursuing external openness through FTAs. Finally, even deeper levels of integration
towards monetary union, such as in the Eurozone, have attempted to facilitate trade by
reducing the uncertainty that comes from exchange-rate fluctuations between trading
partners.

Exhibit 24: Countries have adopted different models of interaction
on regional and global trade

For the last 40 years, the UK has used membership of the European Union as the vehicle for
pursuing greater ‘openness’

The European Union is the most internally open and integrated of any international market,
with measures to promote openness encompassing the total removal of tariffs and other
physical barriers to trade between its 28 members, including via competition rules to
prevent non-tariff protectionist measures such as dumping and state subsidy. Common EU
standards and regulations are aimed at making it more practical for businesses to operate
throughout the EU, while measures to promote labour and capital mobility have allowed
considerable cross-border investment flows and migration of skills. Within its borders, the
EU has lower barriers to trade – and therefore greater trade and supply-chain integration –
than any other trading bloc in the world.[13]

"

The EU is the most internally open and integrated of any international market.

The EU also promotes global openness with non-EU countries, primarily as a regional bloc in
trade negotiations. EU membership is a crucial component of its members’, not least the
UK’s, attractiveness as places to invest and do business for firms from across the globe.

In principle, the EU’s impact on Britain’s productivity, access to world markets and
attractiveness as a place to do business can be leveraged to enhance the UK’s global role.
However, membership of the EU does entail compromise, and limits the UK’s ability to pursue
other forms of integration with the world economy.

2.4 The UK needs to maximise ‘openness’ to the global economy to boost productivity and
increase exports

If the UK is to be successful in adapting its global trading role to the changing world, it
must overcome the productivity challenge that acts as a drag on its trade performance across
the board. To do this, the UK must pursue even greater levels of openness to the global
economy. Openness to trade, investment and migration can be challenging, but done in the
right way it can drive a virtuous circle of increased productivity and competitiveness that
will support growth and exports.

"

The cornerstone of the UK’s present strategy for driving forward trade and openness is its membership of the European Union.

The rest of the world is also becoming more globalised, open and deeply integrated, with
tariff barriers lower than ever before and non-tariff barriers being lowered to help
facilitate a boom in supply-chain trade. Increasingly, the leading edge of that process is
being driven by regional trade blocs and bilateral deals between them rather than
multilateral negotiations on the WTO model. Britain needs to remain engaged in this
process.

The cornerstone of the UK’s present strategy for driving forward trade and openness is its
membership of the European Union. The EU, which still accounts for around half of the UK’s
trade, is the world’s most ambitious trade bloc, where the dismantling of internal
non-tariff barriers to trade has gone the furthest.

However, the EU’s Single Market is far from perfect and membership entails compromises that
in some cases limit Britain’s choices and might in practice do harm to its openness and
prosperity. An assessment is needed as to whether the EU has been, and still is, the best
way for Britain to underpin its global future, driving openness and raising productivity.
Chapter 3 begins this assessment with an examination of the evidence on where membership has
been of benefit and where it has been costly.

References

[2] Sebastian Edwards, ‘Openness, Productivity and
Growth: What Do We Really Know?’, NBER Working Paper 5978, March 1997

[3] The employment rate of migrants was slightly
lower than UK-born rate, at 67% against 72% in 2012, largely due to lower female labour
force participation. The Migration Observatory, ‘The Fiscal Impact of Immigration in the
UK’,2013